NRI Corner

Simply put, index funds attempt to mirror the performance of a designated benchmark index, by investing in the same stocks and weightage as the index. Conversely, actively managed funds are those, wherein the fund manager banks on his expertise and invests in stocks across sectors and market segments. The intention is to identify investment opportunities and clock attractive returns, and in the process outperform the benchmark index.

For a large section of mutual fund investors in countries like the United States, index funds are "bread and butter" investments. Given the advantages they offer - no loads and lower expenses (vis-à-vis actively managed funds) among others, index funds emerge as preferred options. Furthermore, the fact that a number of actively managed funds fail to match broader indices like S&P 500 only helps the cause of index funds.

More importantly, index funds offer investors the opportunity to invest in the markets in an uncomplicated and convenient manner. The investor doesn't have to worry about understanding the fund house's investment philosophy or decide on the kind of fund to choose - large cap fund, mid cap fund, opportunities fund among others. No wonder, index investing is also termed as "passive investing". In case of index funds all one needs to look at is the expense ratio and the tracking error (i.e. the difference between the returns clocked by the index and those clocked by the index fund).

On the other hand, investors in actively managed funds have to contend with all of the above and more; they also have higher costs (thanks to the fees paid to the fund manager and trading costs among other factors) to deal with. The trade-off lies in the opportunity to clock better returns.

The Indian angle

In the Indian context, mutual funds have a different story to tell. Actively managed funds rule the roost, while index funds are yet to catch on. Perhaps the performance of actively managed funds vis-à-vis index funds can explain the reason for the same. Actively managed funds have been successful in outperforming index funds and have done so by huge margins.

Unlike markets in countries like the United States, which are well-developed and wherein information flows smoothly to all participants, the Indian markets are still in an 'evolutionary' phase. A number of inefficiencies exist, which competent fund managers can utilise to their advantage. This explains why virtually all and sundry, actively managed funds manage to outperform their benchmark indices.

To take this discussion further, we face-off 3 actively managed (diversified equity) funds with 3 index funds. The intention is to obtain a broader picture by going beyond just net asset value (NAV) performance and comparing the two categories on parameters like risk-adjusted return and volatility control.

From the diversified equity funds segment, we have chosen HDFC Equity Fund, Sundaram BNP Paribas Growth Fund and DSP Merrill Lynch Opportunities Fund. Albeit these funds invest in stocks across market segments and sectors, they have conventionally displayed a bias for the large cap segment. From the index funds segment, we have chosen FT India Sensex (a scheme from Franklin Templeton) and HDFC Index which track the BSE Sensex (comprises of 30 stocks) and Nifty Bees, an exchange traded fund which tracks the S&P CNX Nifty (comprises of 50 stocks). Both these indices are largely populated by stocks from the large cap segment.

Returns

Performances on the net asset value (NAV) appreciation front throw up an interesting picture. Over shorter time frames (6-Mth), when the equity markets were at their volatile best, index funds have done significantly better than diversified equity funds and even the indices. HDFC Index (10.5%) manages to surpass all the diversified equity funds and its benchmark i.e. BSE Sensex (9.8%) as well. This is rather surprising and may not necessarily be in the interest of the investor, given that the index fund is expected to mirror the underlying index and not outperform it.

Over the 1-Yr time frame, the variations in performances even out; diversified equity funds and index funds pitch in comparable performances. Diversified equity fund, HDFC Equity (43.2%) pitches in the best performance followed by index fund, HDFC Index (42.8%). BSE Sensex is unmatched with a growth of 43.9%.

Diversified equity funds stamp their authority with a superlative performance over the 3-Yr period (which is the minimum tenure for which one should invest in equities). All the funds comfortably score over their index fund peers. Only FT India Sensex (32.1%) has a 5-Yr track record among the index funds, however it is outperformed by all the diversified equity funds over that time frame. Assuming that the index funds had tracked their respective benchmarks to perfection, it would still be safe to conclude that diversified equity funds would have bettered their index fund peers.

Volatility control

Standard Deviation is a measure of the degree of volatility in a fund's performance and in effect the risk that it has exposed its investors to. Index funds hold an edge over diversified equity funds on this parameter. Barring HDFC Equity (5.87%), none of the diversified equity funds have pitched in performances comparable to those of index funds.

Risk-adjusted return

HDFC Equity (Sharpe Ratio 0.54%) from the diversified equity funds segment occupies the top position, followed by HDFC Index (0.50%). Broadly, the performances pitched in by diversified equity funds and index funds on the risk-adjusted return front are comparable.

Expenses

Expectedly, index funds steal the march over diversified equity funds on the expense front. Exchange traded fund, Nifty Bees (0.56%) scores the best followed by peers FT India Index (1.00%) and HDFC Index (1.50%). HDFC Equity (1.93%), the best performer among diversified equity funds is a far cry from the index funds. Clearly, investing in index funds is a more cost-effective option.

To sum up, even in the Indian context, index funds offer advantages like lower expenses (which in turn translate into better returns) and lower volatility in performance over actively managed funds. However over the long-term (which is ideal for evaluating equity-oriented investments), powered by a superlative showing on the returns front, actively managed funds score over index funds.

In effect, for NRIs investing in India, actively managed funds are the way to go; they should occupy a lion's share in the portfolio. Index funds (if at all) should feature only from a diversification perspective.

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